LECTURE 5

FINANCIAL STATEMENT
ANALYSIS

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 CHAPTER
Financial Statement
5 Analysis
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Discuss the need for comparative analysis.
2. Identify the tools of financial statement analysis.
3. Explain and apply horizontal analysis.
4. Describe and apply vertical analysis.
5. Identify and compute ratios used in analyzing a firm’s
liquidity, profitability, and solvency.

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 Basics of Financial Statement Analysis
Learning Objective
Need for Comparative Analysis 1
Discuss the need for
comparative analysis.

 Every item reported in a financial statement has

significance.

 Various analytical techniques are used to evaluate

the significance of financial statement data.

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 Basics of Financial Statement Analysis
Learning Objective 2
Identify the tools of
Analyzing financial statements financial statement
involves: analysis.

Comparison Tools of
Characteristics
Bases Analysis

 Liquidity  Intracompany  Horizontal

 Profitability  Industry  Vertical
 Solvency averages  Ratio
 Intercompany

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 Horizontal Analysis
Learning Objective
Horizontal analysis, also called trend 3
Explain and apply
analysis, is a technique for evaluating a horizontal analysis.

series of financial statement data over a period of time.

 Purpose is to determine the increase or decrease

that has taken place.

 Commonly applied to the statement of financial

position, income statement, and retained earnings
statement.

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 Horizontal Analysis
Illustration 14-5
Horizontal analysis of
statements of financial
position

Changes suggest
that the company
expanded its asset
base during 2017
and financed this
expansion primarily
by retaining income
rather than assuming
additional long-term
debt.

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 Horizontal Analysis
Illustration 14-6
Horizontal analysis of
Income statements

Overall, gross profit

and net income were
up substantially.
Gross profit
increased
17.1%, and net
income, 26.5%.
Quality’s profit trend
appears favorable.

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 Horizontal Analysis

Illustration 14-7
Horizontal analysis of In the horizontal analysis of the statement of financial
retained earnings
statements position the ending retained earnings increased 38.6%. As
indicated earlier, the company retained a significant portion
of net income to finance additional plant facilities.

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 Vertical Analysis
Learning Objective 4
Vertical analysis, also called common-sizeDescribe and apply
vertical analysis.

analysis, is a technique that expresses each

financial statement item as a percent of a base amount.

 On an income statement, we might say that selling

expenses are 16% of net sales.

 On a statement of financial position, we might say

that current assets are 22% of total assets.

 Vertical analysis is commonly applied to the

statement of financial position and the income
statement.
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 Vertical Analysis
Illustration 14-8
Vertical analysis of
statements of financial
position

These results
reinforce the earlier
observations that
Quality is
choosing to
finance its growth
through retention
of earnings rather
than through
issuing additional
debt.

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 Vertical Analysis
Illustration 14-9
Vertical analysis of
Income statements

Quality
appears
to be a
profitable
enterprise that
is becoming
even more
successful.

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 Vertical Analysis
Enables a comparison of companies of different sizes.

Illustration 14-10
14-12 Intercompany income statement comparison LO 4
 Ratio Analysis
Learning Objective 5
Ratio analysis expresses the relationship Identify and compute
ratios used in analyzing a
among selected items of financial statement firm’s liquidity,
profitability, and solvency.
data.
Financial Ratio Classifications

Liquidity Profitability Solvency

Measure short-term Measure the Measure the ability

ability of the income or operating of the company to
company to pay its success of a survive over a long
maturing obligations company for a given period of time.
and to meet period of time.
unexpected needs
for cash.
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 Ratio Analysis

Liquidity Ratios

Measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for
cash.

 Short-term creditors such as bankers and suppliers

are particularly interested in assessing liquidity.

 Ratios include the current ratio, the acid-test

ratio, accounts receivable turnover, and
inventory turnover.
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 Ratio Analysis Liquidity Ratios

1. CURRENT RATIO
Illustration 14-12

2017 2016

Ratio of 2.96:1 means that for every dollar of current

liabilities, Quality has €2.96 of current assets.
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 Ratio Analysis Liquidity Ratios

2. ACID-TEST RATIO
Illustration 14-13

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 Ratio Analysis Liquidity Ratios

2. ACID-TEST RATIO
Illustration 14-14

2017 2016

Acid-test ratio measures immediate liquidity.

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 Ratio Analysis Liquidity Ratios

3. ACCOUNTS RECEIVABLE TURNOVER

Illustration 14-15

2017 2016

Measures the number of times, on average, the company

collects receivables during the period.
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 Ratio Analysis Liquidity Ratios

Accounts Receivable
Turnover
€2,097,000
= 10.2 times
(€180,000 + €230,000) ÷ 2

A variant of the Accounts Receivable Turnover ratio is to

convert it to an AVERAGE COLLECTION PERIOD in
terms of days.

365 days ÷ 10.2 times = every 35.78 days

Receivables are collected on average every 36 days.

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 Ratio Analysis Liquidity Ratios

4. INVENTORY TURNOVER
Illustration 14-16

2017 2016

Measures the number of times, on average, the inventory

is sold during the period.
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 Ratio Analysis Liquidity Ratios

Inventory Turnover

€1,281,000
= 2.3 times
(€500,000 + €620,000) ÷ 2

A variant of inventory turnover is the DAYS IN

INVENTORY.
365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among

industries.

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 Ratio Analysis

Profitability Ratios

Measure the income or operating success of a company

for a given period of time.
 Income, or the lack of it, affects the company’s ability
to obtain debt and equity financing, liquidity position,
and the ability to grow.
 Ratios include the profit margin, asset turnover,
return on assets, return on ordinary shareholders’
equity, earnings per share, price-earnings, and
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payout ratio.
 Ratio Analysis Profitability Ratios

5. PROFIT MARGIN
Illustration 14-17

2017 2016

Measures the percentage of each dollar of sales that

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results in net income. LO 5
 Ratio Analysis Profitability Ratios

6. ASSET TURNOVER
Illustration 14-18

2017 2016

Measures how efficiently a company uses its assets to

generate sales.
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 Ratio Analysis Profitability Ratios

7. RETURN ON ASSET
Illustration 14-19

2017 2016

An overall measure of profitability.

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 Ratio Analysis Profitability Ratios

8. RETURN ON ORDINARY SHAREHOLDERS’

EQUITY Illustration 14-20

2017 2016

Shows how many euros of net income the company

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 Ratio Analysis Profitability Ratios

9. EARNINGS PER SHARE (EPS)

Illustration 14-21

2017 2016

A measure of the net income earned on each ordinary

share.
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 Ratio Analysis Profitability Ratios

10. PRICE-EARNINGS RATIO

Illustration 14-22

2017 2016

Reflects investors’ assessments of a company’s future

earnings.
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 Ratio Analysis Profitability Ratios

11. PAYOUT RATIO

Illustration 14-23

2017 2016

Measures the percentage of earnings distributed in the

form of cash dividends.
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 Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a company to

survive over a long period of time.
 Debt to Total Assets and
 Times Interest Earned

are two ratios that provide information about debt-

paying ability.

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 Ratio Analysis Solvency Ratios

12. DEBT TO TOTAL ASSETS RATIO

Illustration 14-24

2017 2016

Measures the percentage of the total assets that creditors

provide.
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 Ratio Analysis Solvency Ratios

13. TIMES INTEREST EARNED

Illustration 14-25

2017 2016

Provides an indication of the company’s ability to meet

interest payments as they come due.
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 Ratio Analysis

Summary of Ratios
Illustration 14-26

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 Summary of Ratios
Illustration 14-26

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 Summary of Ratios
Illustration 14-26

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 > DO IT!

Summary financial information for Rosepatch Company is as

follows.

Compute the amount and percentage changes in 2017 using

horizontal analysis, assuming 2016 is the base year.

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